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Full text of "Tax revision issues, 1976 (H.R. 10612)"

[COMMITTEE PEINT] 



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TAX REVISION ISSUES— 1976 
(H.R. 10612) 



4 



BUSINESS RELATED INDIVIDUAL INCOME 
TAX REVISIONS 



Prepared for the Use of the 

COMMITTEE ON FINANCE 

BY THE STAFF OF THE 

JOINT COMMITTEE OX INTERNAL REVENUE 
TAXATIO^^*^^/ 




APRIL 14, Wl(\ 



60-53G 



U.S. GOVERNMENT PRINTING OFFICE 
WASHINGTON : 1976 



JCS-11-76 



Digitized by the Internet Archive 
in 2013 



http://archive.org/details/itaxsueOOunit 



CONTENTS 



Introduction 1 

1 . Business use of homes 1 

2 . Vacation homes 3 

3 . Foreign convention expenses 5 

4. Qualified stock options 8 

5 . Treatment of losses from nonbusiness guarantees 10 

6. Away from home expenses of State and congressional legislators 12 

(in) 



INTRODUCTION 

This pamphlet presents background information regarding a series 
of matters contained in the House-passed bill (H.R. 10612) relating to 
the income tax deduction of business or investment related expenses of 
individuals. This pamphlet discusses in each case the present law treat- 
ment, the issues which have been raised and how these matters are 
dealt with in the House-passed bill. Subsequent pamphlets will dis- 
cuss alternative proposals for dealing with these problems. 

The matters discussed in this pamphlet include the tax treatment of 
expenses related to the business use of homes, vacation homes and 
foreign conventions, the tax treatment of qualified stock options, the 
treatment of losses from nonbusiness guarantees, and the away from 
home expenses of state and congressional legislators. 

1. Business Use of Home 

Present law 

Under present law, deductions are allowed for personal, living, and 
family expenses only to the^extent expressly allowed under the code. 
Generally, expenses and losses attributable to a dwelling which is oc- 
cupied by a taxpa} T er as his personal residence are not deductible. 
However, deductions for interest, certain taxes, and casualty losses 
attributable to a personal residence are allowed under other provisions 
of the tax laws. In addition, if a portion of the residence is used in the 
taxpayer's trade or business or is used in the production of income, a 
deduction may be allowed for a portion of the expenses incurred in 
maintaining the residence. 

In any case involving the business use of a personal residence, it 
must be established that the expenses were incurred in carrying on a 
trade or business or for the production of income. Under the regula- 
tions, the expenses of maintaining a household are treated as non- 
deductible if the taxpayer only incidentally conducts business in his 
home. However, if a part of the house is used as the taxpayer's place of 
business, the allocable portion of the expenses attributable to the use of 
the home as a place of business is allowed as a deduction. 

For this purpose the expenses attributable to the business use of 
the home are deductible if they are ''ordinary and necessary" expenses 
paid or incurred in carrying on a trade or business or for the production 
of income. Deductions are allowed self-employed individuals who use 
portions of their residences for trade or business purposes, employees 
who maintain office^ in connection with the performance of their duties 
as employees, or investors who maintain offices in connection with 
investment activities. Typically, the expon-es for which a deduction 
is claimed include a portion of the depreciation or rent, maintenance, 
utility, and insurance expenses incurred in connection with the 
residence. 

The position of the Internal Revenue Service is that the mainte- 
nance of the office in the home must be required by the employer as a 

(l) 



condition of employment and regularly used for the performance of 
the employee's duties. Certain courts have decided that a more liberal 
standard is appropriate. Under these decisions, the expenses attribut- 
able to an office maintained in an employee's residence are deductible 
if the maintenance of the office is "appropriate and helpful" to the em- 
ployee's business: George H. Newi, T.C. Memo. 1969-131, aff'd 432 
F. '2d 998 (2d Cir. 1970); Jay R. GUI, T.C. Memo. 1975-3; Hall v. 
United States, 387 F. Supp. 612 (D.C.N.H., 1975). 

In Stephen A. Bodzin, 60 T.C. 820 (1973), the Tax Court, in allowing 
a deduction for an office in an employee's residence, held that "the 
applicable test for judging the deductibility of home office expenses is 
whether, like any other business expense, the maintenance of an 
office in the home is appropriate and helpful under all the circum- 
stances." However, the court cautioned that no deduction would be 
allowable if personal convenience were the primary reason for main- 
taining the office notwithstanding any conclusion as to the "appro- 
priateness" and "helpfulness" of the office. On appeal, the Fourth 
Circuit reversed the decision of the Tax Court (509 F. 2d 679). The 
Appellate Court held that, as a factual matter, the expenses attrib- 
utable to the taxpayer's residence were nondeductible personal ex- 
penses and that it was therefore unnecessary to decide if the mainte- 
nance of the office was appropriate and helpful in carrying on his 
business. The court suggested that to obtain a deduction, an employee 
would have to show that the office provided by the employer is not 
available at the times the employee uses the office in his residence or 
that the employer's office is not suitable for the purposes for which the 
taxpayer is using the office in his residence. 1 

In determining the deductible amount attributable to the business 
use of the home, the general rule is that any reasonable method oi allo- 
cation may be used. In all cases involving the dual use of a home, the 
allocation of expenses attributable to the portion of the residence used 
for business purposes is to take into account the space used for those 
purposes, e.g., a percentage of the expenses based on the square feet of 
that portion compared to the total square feet of the residence. In addi- 
tion, a further allocation based on time of use is required. The Internal 
Revenue Service has ruled that this allocation should be made on the 
basis of availability for use rather than actual use. However, the Tax 
Court has held that such expenses should be allocated on the basis of 
actual business use as compared with actual total use. 

In another case where the allocation between business use and per- 
sonal use could not clearly be determined, the allocation was made 
on the basis of the approximate space of an apartment which was used 
for business purposes. 

Issue 

Some favor a definitive rule to resolve the conflict that exists 
between several recent court decisions and the position of the Internal 
Revenue Service to determine the deductibility of expenses attribut- 
able to the maintenance of an office in the taxpayer's personal 
residence. 

It is pointed out that under the "appropriate and helpful" standard 
employed in the court decisions the determination of the allowance of 



1 The Supreme Court denied certiorari in the Bodzin case on October 6, 1975 
(44 U.S.L.W. 3201). 



a deduction for these expenses is necessarily a subjective determina- 
tion. In the absence of definitive controlling standards, it is stated that 
the ''appropriate and helpful" test increases the inherent administra- 
tive problems because both business and personal uses of the residence 
are involved. It is also argued that in many cases the application of the 
appropriate and helpful test results in treating personal, living, and 
family expenses directly attributable to the home (and therefore not 
deductible) as ordinary and necessary business expenses, even though 
those expenses did not result in additional or incremental costs incurred 
as a result of the business use of the home. Thus, it is contended that 
expenses otherwise considered nondeductible personal, living, and 
family expenses are converted into deductible business expenses 
simply because, under the facts of the particular case, it was appro- 
priate and helpful to perform some portion of the taxpayer's business 
in his personal residence even though only minor incremental expenses 
were incurred in order to perform these activities. 

The House bill 

Under the House bill, the taxpayer would not be permitted to 
deduct any expenses attributable to the use of his home for business 
purposes except as provided below. 

Deductions for expenses attributable to the use of a portion of the 
taxpayer's residence for business use would be permitted with respect 
to the portion of the home used exclusively on a regular basis asi 

(1) the taxpayer's principal place of business, or 

(2) a place of business which is used for patients, clients, or 
customers in meeting or dealing with the taxpayer in the normal 
course of business. 

However, under these two exceptions, deductions could not exceed 
the income generated by the business activity of the taxpa} r er in 
his home. Deductions would be permitted for certain inventory 
storage. In addition, in the case of an employee, the business use 
must be for the convenience of his employer. 

This provision would apply to taxable years beginning after De- 
cember 31, 1975. 

2. Vacation Homes 
Present law 

Under present law, in order to be entitled to a deduction for business 
or investment expenses, it is necessary that the activity in which 
such expenses are incurred be engaged in by the taxpayer for profit 
(i.e., for the purpose of or with the intention of making a profit). 1 
The determination of whether an activity is engaged in for profit is 
made on the basis of objective standards, taking into account all 
facts and circumstances of each case. Although a reasonable ex- 
pectation of profit is not required, the facts and circumstances (without 
regard to the taxpayer's subjective intent) must indicate that the 
taxpayer entered the activity or continued the activity with the 
objective of making a profit. However, a deduction is allowed for 
interest, State and local property taxes, and casualty losses without 
regard to whether they are incurred in connection with a trade or 
business or for the production of income 



In addition, in the case of an activity not engaged in for profit, a 
deduction is allowed for expenses which could be deducted if the 
activity were engaged in for profit, but only to the extent these 
expenses do not exceed the amount of gross income derived from the 
activity reduced b}^ the deductions which are allowed in any event 
(e.g., interest and certain State and local taxes). In other words, as to 
expenses such as depreciation, insurance, and maintenance, a taxpayer 
is allowed a deduction but only to the extent of income derived from 
the activity. 

A taxpayer is presumed to be engaged in an activity for profit if, 
in two or more years out of the last five years (seven years in the case 
of the breeding, training, showing, or raising of horses) the activity 
was carried on at a profit. For this purpose an activity is treated as 
being carried on for a profit in a } r ear if the gross income from the 
activity exceeds the deductions attributable to it. 

The Regulations provide a list of factors to be taken into account in 
determining whether the activity is engaged in for profit. Among other 
factors, the presence of personal motives must be considered, especially 
where there are recreational or personal elements involved. 2 By way of 
illustration, the regulations provide that a taxpayer will be treated as 
holding a beach house primarily for personal purposes if, during a 
three-month season, the beach house is personalty used by the taxpayer 
for one month and used for the production of rents for the remaining 
two months. However, except for this example, there are no definitive 
rules relating to how much personal use of vacation property will 
result in a finding that the rental activities of vacation homes are 
not engaged in for profit. 

Issue 

Where expenses attributable to a residence are treated as deductible 
business expenses, it has been argued that an opportunity exists to con- 
vert nondeductible personal, living and family expenses into deductible 
expenses. In the case of so-called 'Vacation homes" that are used both 
for personal purposes and for rental purposes, many feel that fre- 
quently personal motives predominate and the rental activities are 
undertaken to minimize the expenses of ownership of the property 
rather than to make an economic profit. 

It has been pointed out that in selling vacation homes, it is common 
practice to emphasize that tax benefits can be obtained by renting the 
property during part of the year, while reserving the remaining portion 
for personal use. In addition, arrangements have been devised whereby 
an individual owner of a condominium unit is entitled to exchange 
the time set aside for the personal use of his own unit (typically three 
to six weeks) for the use of a different unit under the same general 
management. 

Under many of these arrangements, it is suggested that it is ex- 
tremely difficult under existing law to determine when an activity is 
engaged in for profit. It is noted that the present regulations provide 
that, in making this determination, a number of factors shall be taken 
into account. These factors include the presence of "personal motives," 
especially where there are recreational or personal elements involved. 



1 Sec Morton v. Commissioner, 174 F. 2d 302, 304 (2d Cir.), cert, denied, 338 
U.S. S2S (1949); Schley v. Commissioner, 375 F. 2d 747 (2d Cir. 1967) ; and George 
W. Mitchell, 47 T.C. 120 (1966). 



5 

However, except for the example mentioned above, no objective stand- 
ards are set forth in the regulations. As a result, many believe that 
definitive rules need to be provided to specify the extent to which per- 
sonal use would result in the disallowance of deductions in excess of 
gross income. It is suggested that this approach would obviate the need 
to require subjective determinations to be made concerning the tax- 
paver's motive and the primarv purpose for which the vacation home is 
held. 

In addition, if there is any personal use of a vacation home, it has 
been urged that the portion of expenses allowable to rental activities 
should be limited to an amount determined on the basis of the ratio 
of time the home is actually rented to the total time the vacation 
home is used during the taxable year for all purposes (i.e., rental, 
business, and personal activities). 

The House bill 

Under the House bill, if a vacation home is used b}' a taxpayer foi 
personal purposes for the greater of 2 weeks or 5 percent of the actua) 
business use (that is its actual rental time), the deductions incurred 
in connection with a vacation home, which would be allowed cannot 
exceed the gross income from the business use of the vacation home. 
These rules would not apply if the rental of a vacation home results in a 
profit for the year. 

In addition, where the 2 weeks or 5-percent rule applies, the deduc- 
tions treated as being attributable to the rental activities would be 
limited to the proportion which actual rental use bears to the total 
actual use of the propert} r (that is, business use plus personal use) 
times the business expenses attributable to the vacation home (other 
than expenses which are allowable in any event, such as interest and 
taxes) . 

This provision would apply to taxable years beginning after Decem- 
ber 31, 1975. 

3. Foreign Convention Expenses 

Present law 
Generally, to be deductible, traveling expenses must be reasonable 
and necessary in the conduct of the taxpayer's business and directly 
attributable to the trade or business. If a trip is primarily related to 
the taxpayer's business and the special foreign travel allocation rules 
do not apply, the entire traveling expenses (including food and lodg- 
ing) to and from a destination are deductible. If a trip is primarily 
personal in nature, the traveling expenses to and from the destination 
are not deductible even if the taxpayer engages in business activities 
while at the destination. 1 However, expenses incurred while at the des- 
tination which are allocable to the taxpa} T er's trade or business are 
deductible even if the transportation expenses are not deductible. 

2 Treas. Reg. § 1.183-2(b). These factors include: (1) The manner in which the 
taxpayer carries on the activity, (2) the expertise of the taxpayer or his advisors, 
(3) the time and effort expended by the taxpayer in carrying on the activity, (4) 
the expectation that assets used in the activity may appreciate in value, (5) the 
success of the taxpayer in earring on other similar or dissimilar activities, (6) the 
taxpayer's history of income or losses with respect to the activity. (7) the amount of 
occasional profits, if any, which are earned, (8) the financial status of the taxpayer, 
and (9) the elements of personal pleasure or recreation. 

1 See Patterson v. Thomas. 289 F. 2d 108 (5th Cir. 1961); Espandiar Kadivar, 
T.C. Memo 1973-95; Rev. Rul. 74-292, 1974-1 C.B. 43. 

69-5S0— 70 J 



6 

With respect to expenses incurred in attending a convention or 
other meeting, the test is whether there is a sufficient relationship 
between the taxpayer's trade or business and his attendance so that 
he is benefiting or advancing the interests of his trade or business. 
Generally, deductibility depends upon the facts and circumstances 
of each particular case. If the convention is for political, social, or 
other purposes unrelated to the taxpayer's business, the travel 
expenses are not deductible. The Internal Revenue Service has ruled 
that the test for allowance of deductions for convention expenses 
is met if the agenda of the convention or other meeting is so related 
to the taxpayer's position as to show that attendance was for business 
purposes. 

If an individual travels away from home primarily to obtain edu- 
cation for which the expenses are deductible as trade or business ex- 
penses, the expenses for travel, meals, and lodging incurred while 
away from home are deductible. However, the portion of the travel 
expenses attributable to personal activities, such as sightseeing, is 
treated as a nondeductible personal or living expense. If the travel 
away from home is primarily personal, only the meals and lodging 
incurred during the time spent in participating in educational pur- 
suits are deductible. 

Expenses of travel outside the United States are deductible only to 
the extent they are allocable to the taxpayer's trade or business 
or income-producing activities if the travel is for more than one week 
or the time of travel outside the United States which is personal 
is 25 percent or more of the total time on such travel. In the case of 
foreign travel, this allocation requirement overrides the general rule 
that the entire expenses of travel are deductible if the primary purpose 
of the trip was related to a trade or business. 

Issue 

Questions have been raised as to the recent proliferation of con- 
ventions, educational seminars, and cruises which are ostensibly held 
for business or educational purposes, but which, it is alleged, are 
held at locations outside the United States primarily because of the 
recreational and sightseeing opportunities. The Internal Revenue 
Service has announced that it intends to scrutinize deductions for 
business trips, conventions, and cruises which appear to be vacations 
in disguise. The Service noted that a number of professional, business 
and trade organizations have been sponsoring cruises, trips and con- 
ventions during which only a small portion of time is devoted to 
business activity and that the practice seemed to be growing. In 
cases where there are indications of abuse, the Service intends to 
request lists of the names and addresses of the participants on cruises 
and other trips. However, allowance of deductions claimed by partici- 
pants would continue to depend upon the facts and circumstances, 
including the relationship of the meeting to a particular taxpayer's 
trade or business, as under present law. 

As indicated above, the basic test applied by the Internal Revenue 
Service is whether the convention or other meeting is primarily 
related to the taxpayer's business or whether it is primarily personal 
in nature. In administering this test, the Internal Revenue Service 
is required to make a subjective determination as to the motives and 
intentions of the taxpayer after taking into account all the facts and 



circumstances in a particular case. One of the important factors con- 
sidered by the Service in making this subjective determination 
is the amount of time spent on business activities as compared to the 
amount of time spent on personal activities. There are no specific 
guidelines or formulae in the statute or regulations that specify when 
this factor will weigh in favor of, or against the taxpayer. The tax- 
payer is not required to keep detailed records relating to the amount 
of time spent on each of these activities. Upon audit, the taxpayer 
frequently attempts to substantiate the business nature of his trip by 
providing the Service with the agenda from the meeting or a certifi- 
cate of attendance which is furnished by the organization sponsoring 
the meeting. 2 

The Service has indicated that the administrative problems created 
by the lack of specific guidelines are substantial. The process of trying 
to ascertain all the facts and circumstances is extremely time consum- 
ing both for the taxpayer and the Service. It has been suggested that 
it is particularly difficult for the Service because of the basically "all or 
nothing" approach for transportation expenses under present law. If 
the primary purpose is determined to be pleasure, no amount of the 
travel expense can be deducted. Since reasonable and competent 
auditors will differ in evaluating all the facts and circumstances, it is 
suggested that the deduction of one taxpayer may be totally dis- 
allowed while another taxpayer (perhaps with slightly different facts) 
can obtain a complete deduction for travel expenses. This disparity 
of treatment results in complaints that the Service does not treat 
taxpayers equally. 

Some believe that the lack of specific detailed requirements has 
resulted in a proliferation of foreign conventions, seminars, cruises, 
etc. which, in effect, amount to Government-subsidized vacations and 
serve little, if any, business purpose. The promotional material often 
highlights the deductibility of the expenses incurred in attending a 
foreign convention or seminar and, in some cases, describes the meet- 
ing in such terms as a "tax-paid vacation" in a "glorious" location. In 
addition, there are organizations that advertise that they will find a 
convention for the taxpayer to attend in any part of the world at any 
given time of the year. It has been suggested that this type of promo- 
tion has an adverse impact on public confidence in the fairness of the 
tax laws. 

The House bill 

Under the House bill, a limitation would be imposed on deductions 
allowable for the expenses of taxpayers attending conventions, educa- 
tional seminars, or similar meetings outside the United States, its 
possessions and the Trust Territory of the Pacific. Deductions would 
be allowed for expenses incurred in attending not more than two for- 
eign conventions per year. With respect to these two conventions, the 
amount of the deduction for transportation expenses could not exceed 
the cost of airfare based on coach or economy class. Transportation 
expenses would be deductible in full only if more than one-half of the 
total days of the trip (excluding the days of transportation to and from 
the site of the convention) are devoted to business-related activ. 



2 A few organizations now maintain attendance records and require participant 
to "sign in" at each session of the convention or seminar. 



8 

If less than one-half of the total days of the trip are devoted to busi- 
ness related activities, no deduction would be allowed for that portion 
of the transportation expenses attributable to non-business-related 
activities. 

In addition, deductions for subsistence expenses, such as meals, 
lodging, and other ordinary and necessary expenses, paid or incurred 
while attending the convention would be limited to the fixed amount 
of per diem allowed to government employees at the location where 
the convention is held. However, in order to be able to deduct subsist- 
ence expenses up to this limitation, there must generally be at least 6 
hours of business-related activities scheduled daily and the taxpayer 
must have attended two-thirds of these activities. 

This provision would apply to conventions held after December 31, 
1975. 

4. Qualified Stock Options 

Present law 

An employee stock option is a relatively low risk'means of acquiring 
an equity interest in a corporation, since the option need not be 
exercised unless the value of the stock increases during the option 
period. If the value of the stock drops below the price at which the 
stock may be purchased (i.e., below the option price), the employee can 
allow the option to lapse (although ordinarily the employee would lose 
the amount which he may have originally paid for the option, if any). 

Under present law, no income is recognized on the grant to a cor- 
porate employee, or on his exercise of, a "qualified" option to receive 
stock in the employer corporation. The stock acquired by the exercise 
of the option is a capital asset in the hands of the employee and the 
income realized from the eventual sale of the stock is generally treated 
as long-term capital gain or loss. 1 

No deduction is available to the employer, as a business expense 
with respect to either the granting of a qualified stock option or the 
transfer of stock to the employee when he exercises a qualified option. 

A qualified option must be granted pursuant to a plan approved by 
the shareholders of the corporation. The option must, by its terms, be 
exercised within 5 years from the date it is granted and the purchase 
price of the shares (option price) may not be less than the fair market 
value of the company's stock on the date when the option is granted 
to the employee. In addition, any stock acquired under a qualified 
option may not be disposed of within 3 years after it is transferred to 
the employee. The option must also be exercised while the option 
holder is an employee of the corporation, or within three months after 
the termination of his employment. 

By contrast, the value of a nonqualified stock option generally repre- 
sents ordinary income to the employee if the option itself had a readily 
ascertainable fair market value at the time it was granted to the 
employee. If the option did not have a readily ascertainable value 
when granted, it would not constitute ordinary income at the time it 
was granted but when it is exercised the spread between the option 

1 Generally similar tax treatment is also available in the case of "restricted 
stock options," which were the predecessors to qualified options, but restricted 
stock options are no longer being granted, and most restricted options which 
were granted in the past have now been exercised or have lapsed. 



9 

price and the value of the stock at that time constitutes ordinary 
income to the employee. 

Although an employee does not have to pay tax under the qualified 
stock option rules at the time he exercises the option and receives 
stock worth more than he paid for it, the bargain element is treated 
as an item of tax preference under present law. This means that the 
excess of the fair market value of the share at the time of exercise over 
the purchase price paid by the employee is subject to the 10-percent 
minimum tax under present law. 

Issue 

The principal reason for the present tax treatment of qualified stock 
options is said to be that such treatment allows corporate employers to 
provide "incentives" to key employees by enabling these employees to 
obtain an equity interest in the corporation. However, questions have 
been raised as to whether a qualified stock option gives key employees 
more incentives than do any other form of compensation, especially 
since the value of compensation in the form of a qualified option is 
subject to the uncertainties of the stock market. It is also noted that 
the market price of a company's stock is subject to many variables and 
the connection between an employee's own efforts and the value of the 
stock is, at best, speculative, particularly in the case of a large publicly 
traded corporation with many employees. Moreover, to the extent 
there is an incentive effect resulting from stock options, it is argued 
that present law discriminates in favor of corporations (which are the 
only kind of employers who can grant qualified options) as opposed to 
all other forms of business organization. 

Qualified stock options have become less attractive as a compensa- 
tion technique in recent years because of the generally declining stock 
market of recent years. The market price of stocks of many publicly 
held companies has dropped substantially in the recent recession. As a 
result, many qualified stock options granted in previous years at pur- 
chase prices which seemed attractive on an assumption that the price 
of the company's stock would rise became unattractive as the price of 
the outstanding stock fell. Many executives thus had no incentive to 
exercise then- options which were "under water," i.e. options whose ex- 
ercise price was higher than the current level of the company's stock 
in the open market. Because of this loss-of-incentive feature many 
companies have turned to other techniques and plans as a way to 
compensate their executives. 

Some companies, however, have gone ahead and granted new quali- 
fied options to their executives at the currently depressed market 
prices of their stock. The rationale has been that the executives may 
still be able to benefit by the new options if the price of the stock does 
increase in the years ahead and if the executives do not have to wait 
too long to exercise the new options. In some cases, such new grants of 
qualified stock options to executives in the recession has produced 
increasing criticism from the shareholders of the companies. Some such 
shareholders have argued that the grant of new qualified options 
enables the companies' executives to avoid taking the same business 
risks that the shareholders generally are taking with regard to the 
company's fortunes. 



10 

The House bill 

Under the House bill, in the future, qualified stock options would be 
subject to the same rules as presently apply in the case of most non- 
qualified options. Generally, the value of the option would constitute 
ordinal income to the employee if it had a readity ascertainable fair 
market value at the time it was granted (and was not nontransferable 
and subject to a substantial risk of forfeiture). If the option did not 
have a readity ascertainable value, it would not constitute ordinary 
income at the time it was granted, but when the option was exercised 
the spread between the option price and the value of the stock would 
constitute ordinary income to the employee. 

In general, the new rules would apply to options granted after 
September 23, 1975, but would not apply to options granted on or 
before this date. This is true even though the option is exercised in the 
future (so long as it meets the terms of the present rules of a qualified 
option). In addition, transition rules would be provided for options 
granted after September 23, 1975, pursuant to a written plan adopted 
and approved before September 24, 1975; for options granted after 
September 23, 1975, under a qualified plan adopted by a board of 
directors before September 24, 1975, even if the plan was approved by 
the shareholders after that date; and for substitute options granted 
after September 23, 1975, as a result of a corporate reorganization or 
similar transaction provided that no modification of the former option 
occurs. The transition rules cover these options as long as they are 
exercised before September 24, 1980. 

These rules would apply to taxable years ending after September 23, 
1975. 

5. Treatment of Losses From Certain Nonbusiness Guaranties 

Present law 

Under present law, in the case of a noncorporate taxpayer, business 
bad debts are deductible as ordinary losses for the year in which the 
debt becomes worthless or partially worthless. On the other hand, non- 
business bad debts are treated as short-term capital losses, which 
means that the losses are offset first against the taxpayer's capital 
gains (if any), and may then be deducted against ordinary income 
to the extent of $1,000 per year. 

However, where the noncorporate taxpayer's loss results from a situ- 
ation where he guaranteed the debt of a noncorporate person, and was 
required to make good on that guaranty because the borrower de- 
faulted, present law provides that the guarantor may treat the pay- 
ment under the guaranty as a business bad debt (even though the 
guaranty did not arise in connection with the guarantor's trade or 
business) if the proceeds of the loan were used by the borrower in 
his trade or business. However, the guarantor of a corporate obligation 
which becomes worthless must treat the guaranty payment as a non- 
business bad debt. 

If the loan is not used in the borrower's trade or business, the 
guarantor's payment will still be deductible as a nonbusiness bad 
debt (short-term capital loss) if the debt is worthless when paid and 
the guarantor has a right of reimbursement (subrogation) against the 
borrower. 1 



11 

In cases where the guarantor has no right of subrogation, there has 
been some uncertainty as to whether, and under what circumstances, 
the guarantor was entitled to deduct his guaranty payment. For some 
time it was believed that the payment could not be deducted as a bad 
debt on the theory that unless there is a right of recovery against the 
borrower, there is no "debt" which might become worthless in the 
hands of the guarantor. However, if the guaranty transaction was 
entered into in connection with the taxpayer's trade or business, or the 
agreement was part of a transaction entered into for profit on the part 
of the taxpayer, then the payment was thought to be deductible as a 
loss under section 165. 

Recently, courts have found an implied promise on the part of the 
borrower to reimburse the guarantor for his payments, and holding 
that this implied promise constituted the bad debt. 2 Thus, taxpayers 
w T ere required to claim their deduction under section 166. However, 
there is no assurance that the rationale of these cases will be appli- 
cable in all fact situations where there is potential for avoidance of 
the bad debt rules, or that these opinions will be followed in every 
jurisdiction. 

Issue 

As discussed above, where a taxpayer makes a loan which is not 
connected with his trade or business, and the debt becomes worthless, 
he is generally required to treat the loss as a short-term capital loss. 
On the other hand, it is pointed out that where the taxpayer and the 
borrower can persuade a third part}' to make the loan, which is 
guaranteed by the taxpayer, and the proceeds of the loan are used by 
the borrower in his trade or business, the loss, if one results, ma} r 
generally be deducted by the taxpayer against ordinary income. 
Questions have been raised as to whether this distinction makes sense. 
It appears to provide a tax incentive for careful planning, particularly 
in transactions between closely related parties, such as family mem- 
bers, with no emphasis on the actual substance of the loan transaction. 

Another issue is whether there should be clarification in the case of 
a guarantor of a corporate obligation that an}' payment under the 
guaranty agreement must be deducted as a nonbusiness bad debt, 
regardless of whether there is any right of subrogation, unless the 
guaranty was made pursuant to the taxpayer's trade or business. 

The House bill 

Under the House bill, where a taxpayer has a loss arising from the 
guaranty of a loan, he would receive the same treatment as where he 
has a loss from a loan which he makes directly. Thus, if the guaranty 
agreement arose out of the guarantor's trade or business, the guarantor 
would still be permitted to treat the loss as an ordinary loss. If the 
guaranty agreement were a transaction entered into for profit by the 
guarantor (but not as a part of his trade or business) , he would treat 
the loss as a short term capital loss. This rule would also apply in 
the case of a guarantor of a corporate obligation. 

These rules would apph T to taxable years beginning after December 3 1 , 
1975. 



1 If the debt is not worthless, no deduction is generally allowed (on the theory 
that payment by the grantor was voluntary) . 

2 See e.g., Bert W. Martin, 52 T.C. 140 (reviewed bv the Court), aff'd per curiam, 
424 F. 2d 1368 (9th Cir.) cert, denied, 400 U.S. 902 (1970). 



12 

6. Away From Home Expenses of State and Congressional 

Legislators 

Present law 

Under present law, an individual is allowed a deduction for travel- 
ing expenses (including amounts expended for meals and lodging) 
while away from home in the pursuit of a trade or business. These 
expenses are deductible only if they are ordinary and necessary in 
the taxpayer's business and directly attributable to it. "Lavish or 
extravagant" expenses are not allowable deductions. In addition, no 
deductions are allowed for personal, living, and family expenses except 
as expressly allowed under the code. 

Generally, expenses and losses attributable to a dwelling unit which 
is occupied by a taxpayer as his personal residence ar^ not deductible. 
However, deductions for interest, taxes, and casualty losses attrib- 
utable to a personal residence are expressly allowed under other 
provisions of the tax laws. 

A taxpayer's "home" for purposes of the deduction for traveling 
expenses generally means his principal place of business or employ- 
ment. Where a taxpayer has more than one trade or business, or a 
single trade or business which requires him to spend a substantial 
amount of time at two or more localities, his "home" is held to be at 
his principal place of business. A taxpayer's principal place of business 
is determined on an objective basis taking into account the facts and 
circumstances in each case. The more important factors to be con- 
sidered in determining the taxpayer's principal place of business (or 
tax home) are: (1) the total time ordinarily spent by the taxpa}^er at 
each of his business posts, (2) the degree of business activity at each 
location, (3) the amount of income derived from each location, and 
(4) other significant contacts of the taxpayer at each location. No one 
factor is determinative. 

In 1952, a provision was adopted with respect to the living expenses 
paid or incurred by a Member of Congress (including a Delegate or 
Resident Commissioner). Under these rules, the place of residence of 
a Member of Congress within the congressional district which he 
represents in Congress is considered his tax home. However, amounts 
expended by the Member within each taxable year for living expenses 
are not deductible in excess of $3,000. Therefore, a Member of Con- 
gress (who does not commute on a daily basis from his congressional 
district) l can deduct up to $3,000 of his expenses of living in the 
Washington, D.C. area. 

These rules do not apply in the case of a State legislator. As a 
result, the tax home of a State legislator is determined in accordance 
with the general rules described above. In a situation where a State's 
legislature is in session for a significant portion of the year, that State's 
legislators' homes, may, under these rules, be at the State capital rather 
than in their legislative districts. 

Issue 
In recent years, the sessions of many State legislatures have been 
substantially lengthened. As a result, members of the various legisla- 
tures are required to spend substantial portions of each year in the 

1 Under the "overnight rule," travel away from home expenses (as distinguished 
from transportation expenses) generally cannot be deducted unless the taxpayer 
is away from home on business overnight. 



13 

State capital. In order to reimburse the legislators for the living 
expenses incurred in connection with attending sessions in the State 
capital, many legislatures provide a per diem for each day a legislator 
attends a session of the legislature. 

It is stated that it is extremely difficult for many State legislators 
to determine their tax homes under the facts and circumstances test 
of present law. First the length of time that a State legislature is in 
session may vary substantially from year to year. Moreover, several 
State legislatures meet only once every two years. In addition to the 
variation of time, a legislator's income derived from his place of 
residence and from the State capital will frequently var}'. This 
problem is heightened by the fact that the Internal Revenue Service 
will not issue an advance ruling determining an individual legislator's 
tax home. 

Consistent with their prior practice, many State legislators have con- 
tinued to treat their residences in the districts they represent as their 
tax homes and have filed their Federal income tax returns in accord- 
ance with this practice, thereby deducting living expenses incurred 
in the State capital. The Service is currently challenging this practice 
and determining the tax home of a State legislator on a case-by-case 
basis. In some cases, this has resulted in a determination that the 
legislator's tax home is the State capital and in other cases, that his 
tax home is in the district he represents. If the Service determines 
that a legislator's tax home is the State capital, deductions taken for 
living expenses incurred in connection with the time spent at the 
State capital are disallowed. Although a deduction will then be 
allowed for living expenses incurred in the district the State legislator 
represents, in many cases the taxpayer (not having kept records 
of these expenses since they were not thought to be deductible) will 
not be able to substantiate those expenses. Many state legislators 
consider this inconsistent treatment and view the results as inequitable. 

Furthermore, many believe that the $3,000 limitation (established 
in 1952) on the deductions for living expenses of Members of Congress 
in the Washington, D.C., area is inappropriate since this is much less 
than is generally allowed in the case of business employees who are 
away from home on business overnight. Under present law, if an em- 
ployer reimburses an employee for subsistence or provides an em- 
ployee with a per diem allowance in lieu of subsistence, the employee 
may generally deduct up to $44 per day for subsistence expenses 
incurred in connection with travel away from home (on behalf of his 
employer) without the requirement of substantiation. It is argued that 
legislators (both State and U.S.) should be entitled to treatment 
similar to that accorded other businessmen under present law. 

The House bill 
Under the House bill, for purposes of the deduction of trade or 
business expenses away from home by a State legislator, the home of a 
State legislator would be his place of residence within the legislative 
district which he represents. Deductions by a State legislator would be 
limited to an amount determined by the Internal Revenue Service. 
The IRS would apply rules of reasonableness and would take into 
account certain factors such as the number of days of legislative par- 
ticipation, the cost of living at the place where the legislature meets 



14 

and the amounts normally allowed businessmen under similar cir- 
cumstances. An election would be provided for State legislators with 
respect to past periods. 

Further, under the House bill, the $3,000 limitation would be 
modified to provide that deductions by a Member of Congress would 
be limited to an amount determined by the Internal Revenue Service. 
The IRS would apply rules of reasonableness and would take into 
account certain factors such as the number of days that the Members 
are away from home, the cost of living in Washington, D.C., and the 
amounts normally allowed businessmen under similar circumstances. 

These provisions would apply to taxable years beginning after 
December 31, 1974. 

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